Friday, April 24, 2009

Yields on 30-year T-bonds today hit a new year-to-date high. At 3.88%, they are now 135 bps above their all-time lows of last December. Of all the things that are bouncing these days, rising yields on Treasury bonds are potentially the most significant. Investors drove yields down to incredibly low levels last December, when fear was at its peak and expectations of a global depression and deflation were rampant. To be happy with a 2.5% 30-year Treasury bond, you would have to believe that a) the economy was in for a massive contraction, b) inflation was going to be negative for many years, and c) depression plus deflation would wipe out a huge percentage of the corporate bonds then in existence.

Well, now it's looking like depression and deflation are not so likely after all. Investors are now less eager on the margin to buy Treasuries, even though the Fed has promised to buy lots of them in order to keep yields low and thus help stabilize the housing market. Rising 10-year yields haven't yet pushed mortgage rates up, but the spread between mortgage rates and 10-year Treasuries is unlikely to fall much more. Regardless, you can get 30-year fixed rate conforming loans for 4.8% now, and rates on 30-year jumbos have dropped to 6.2%, according BanxQuote. The spread between jumbo and conforming loans is still very high from an historical perspective, so it could fall a lot more. I don't think fixed rates on conforming loans are going to fall much more, if at all (this may be your last chance to lock in the lowest rates on conforming loans in your lifetime), but jumbo rates could still decline some more even if Treasury yields move higher.

Rising yields on Treasuries are unlikely to kill the housing market recovery anytime soon. Instead, they are an excellent sign that the outlook for the economy is improving. Green shoots are everywhere.

Good question, tough to know the exact answer. One thing that occurs to me is that bill yields are being depressed because of the Fed's massive injections of liquidity. People and banks have all this cash and they don't know what to do with it. Markets are still depressed and fear levels are still high, and confidence in counterparty risk has not yet returned to normal levels.

Another factor could be the way the bond market deals with risk along the yield curve. If you are managing a portfolio of bonds and you begin to worry that the Fed's actions might be inflationary, and/or the economy might pick up even just a little bit, then you would want to reduce your holdings of long maturity bonds, because they will suffer in price more than shorter maturities if yields rise. You're not worried in any event about short term interest rates rising, because the Fed has all but guaranteed that they will keep short rates low until it is clear the economy is on the mend.

So, if you sell your long maturity bonds because you worry about rising yields, you have no choice but to park the proceeds in shorter-maturity bonds or in cash (e.g., T-bills). You can't buy equities or commodities because you have to keep all your money in the bond market--that's your investment mandate.

What I'm describing is a yield curve trade. If you expect long maturity yields to rise, you want to shift funds to the front end of the yield curve to avoid or minimize price declines.

In fact, we have seen the yield curve steepen in recent months, suggesting that people are doing just this: selling long bonds and buying cash. The demand for cash puts downward pressure on T-bill yields.

There is a third factor: with the Fed promising to keep the funds rate near zero for a long time, and banks holding literally TONS of reserves, banks would have an incentive to use their reserves to buy T-bills if the yield on bills exceeded the yield the Fed is paying them on the reserves (which is somewhat less than 0.25%). Arbitrage would have set in when bill yields first rose above the 0.25% funds rate in early February, and that would have added to the downward pressure on bill yields.

So I suppose I saying something equivalent to "the front end of the yield curve is not as responsive to signs of an improving economic outlook as the back end is, for a variety of reasons."

In my opinion, it doesn't help to try to pin a market move on one group of investors or another. If I see T-bond yields rising, it means only one thing: on the margin there are more willing sellers than buyers. The world's desire to own these bonds has declined. They are less attractive than before. That is what I would expect to see happen if deflation and depression expectations are gradually replaced by inflation and growth expectations.

But that same logic would have told you to keep buying IG credit, HY, and structured product right up until the tipping point. Obviously that is what most people did.

If we don not analyze the sources of buying and selling and the rationale behind it, then the information contained in the price action is meaningless. 2007/08 did a good job of highlighting that, I thought.

Rising yields do mean less buyers than sellers, but why that is so does not mean it is an inflation/defaltion call. Times have changed, cross border flows are enormous, and the rationale behind them can be very different than what the market expects.

I'm not forecasting with my comment, only analyzing. The logic in my response says nothing about what an investor should have done in the period leading up to the crisis.

Applying that logic to the events leading up to the crisis would have resulted in the observation--based on extremely tight spreads and very low implied volatility--that investors were extremely optimistic about the future and there was very little margin, if any, for error. That would not have been a recommendation to buy. On the contrary it would have been reason to be very cautious.

The direction of yields (moving up) is one thing, and the level of yields (moving up from extremely low levels) is quite another. When yields were 2% that necessarily implied that investors believed there was a strong possibility of deflation. If yields had risen from 5% to 6% that would have said nothing about deflation expectations.